Option Sellers Beware

In day seven Mark Wolfinger penned a warning for option buyers. I thought it appropriate to provide the yang to Mark’s ying.

I don’t recall where I read that options sellers eat like chickens and shit like elephants, but I sure laughed hard and the phrase still brings a smile to my dial. I’m predominately an option seller and can testify to having been covered by a few large steaming piles in my time.

Experienced traders will extol the virtues of buying protection for written options. That is insuring you’re not naked. Unfortunately those new to the trading options seldom listen to that advice for a number of reasons.

1. Buying protection reduces the attractiveness of a position.
2. Buying protection forces an acknowledgement and assessment of the risk and requires more involved calculations.
3. It won’t happen to me.
4. I’m happy to buy or sell at that strike price.
5. I’ll close the position if it moves against me.

Two words sum up the danger, surprise volatility. In Bleed or Blowup, Nasim Taleb has the following to say

In some strategies and life situations, it is  said, one gambles dollars to win a succession of pennies. In others one risks a succession of pennies to win dollars. While one would think that the second category would be more appealing to investors and economic agents, we have an overwhelming evidence of the popularity of the first. A popular illustration of such asymmetry in returns is evident in the story of the Long  Term Capital Management hedge fund. The fund derived steady returns over a dozen quarters then lost all of them in addition to almost all its capital in a single observation (see Lowenstein, 2000) –only for the main principals to restart a new, albeit milder, version of the strategy. Is there a systematic bias in favor of such return profiles?

That’s right LTCM were options sellers. So if the most intelligent (note I didn’t say smartest) collection of people to ever form a hedge fund blew up selling options, why do newbie option traders think they can better?

How to Overcome the Dangers of Selling Options

Slip, slop, slap. Slip on some protection, slop on some protection, slap on some protection. Buy a lower priced put or higher priced call to protect yourself from surprise volatility.

Invert your thinking. In day five, believing writing covered calls is conservative, I highlighted how covered calls are not as risk free as many investors think. The easiest way to overcome the danger of writing covered calls is to invert your thinking by considering whether you would write a put on the stock at the same strike price. As a put is equivalent a covered call that simple mental gymnastics helps me decide whether I should be writing the covered call or simply selling the stock.

While that takes care of downside risk, which to me is the real risk, many experienced investors have argue that missing out on the upside is an even greater risk. While I disagree, I certainly concede that forfeiting upside is a risk that many investors ignore. Is it worth selling that $50 call for $1 when the at expiration the share could be $60?

When you sell options you are in general forfeiting upside while taking on the downside risk. You’re behaving like an insurance company and as such it pays to re-insure against catastrophic risk.

More:

• Day Eight in this series of options trading mistakes.
• The series so far, ten biggest mistakes in option trading.

Related posts:

1. Day Five: Ten of the Biggest Mistakes in Option Trading
2. Day Seven: Ten of the Biggest Mistakes in Option Trading
3. Day Six Part 2: Ten of the Biggest Mistakes in Option Trading
4. Day Two: Ten of the Biggest Mistakes in Option Trading
5. Day Eight: Ten of the Biggest Mistakes in Option Trading
6. Day Four: Ten of the Biggest Mistakes in Option Trading